Asset-Allocation Heavyweights Square Off

Valley Forge, Pa., and Ellicott City, Md., may be small towns, but they are the breeding grounds of some big investment ideas. Valley Forge is home to Vanguard, the client-owned firm that manages $1.4 trillion in more than 100 U.S. mutual funds. Ellicott City is where John Hussman, a former economics professor, and his firm, Hussman Econometrics Advisors, have operated since 1989. With their combined assets of $7 billion, Hussman's two funds--Hussman Strategic Growth HSGFX and Hussman Strategic Total Return HSTRX-- seem small compared with one of the largest fund families in the world, but their strong risk-adjusted performance and the unique, original research backing them have attracted attention.

While Vanguard has branched out into alternative strategies like long-short and complex asset-allocation vehicles such as its Managed Payout Funds in recent years, it is still regarded as a bastion of traditional, sober, long-term investing. Meanwhile, Hussman's research, which he often publishes on his Web site, frequently challenges conventional wisdom. We thought that getting Vanguard CIO Gus Sauter, who has been with Vanguard for more than 20 years and oversees all of its internally managed funds, and Hussman together to talk shop would result in an interesting Morningstar Conversation. We were right. It was one of the liveliest interactions we've had.

Their exchange on Nov. 3 ranged widely over alternative asset classes, global asset allocation, inflation, and current market valuations. The two differed sharply on many topical subjects, such gold's suitability as a long-term investment, the prospects for higher inflation, and the relevance of the concept of equity duration to asset- allocation strategies, including target-date retirement funds.

Equity duration is an academic idea that has been around since the early 1980s, but it has descended from the ivory tower in recent years and influenced investors, including Hussman. Duration, a measurement usually associated with bonds, measures interest-rate sensitivity and weighted average time to receipt of the bond's cash flows. In bonds, the higher the yield to maturity, the shorter the duration will be.

It turns out that you can also calculate the duration of the stock market. In general, as the market's (dividend) yield rises, its duration decreases, and vice versa. Hussman uses this measurement, among other things, to argue that the glide paths of target-date funds should be dynamic even for an investor with no particular view about market conditions or future returns. Vanguard, like most other target-date fund providers, uses static glide paths.

The conversation has been edited for clarity and length.

Ryan Leggio: Let's start off talking about alternative asset classes. Gus, what types of alternatives do you believe are most appropriate for mainstream investors?

Gus Sauter: Commodities, REITs, and Treasury Inflation-Protected Securities are alternative investment classes that make sense in many people's portfolio allocations.